The recent decision of the People’s Bank of China (PBC) to allow the value of the yuan to depreciate to above ¥7 to the US dollar alarmed currency markets. Many media commentators were talking up the onset of ‘currency wars’ and China’s manipulation of its currency to counter President Trump’s decision to further increase US tariffs on Chinese goods. These commentators are often the same ones who point to the large share of exports in China’s GDP and blame US trade deficits on China’s perceived undervalued currency.
Many people continue to be unaware that we now live in a world of global supply chains. A country’s exports are not solely made inside that country; a country sources many inputs from other countries to produce a final product for export. This is particularly true for China. It became known as the ‘world’s factory’, largely because it is very adept at assembling imported high-value components into finished products. The Taiwanese company Foxconn, which assembles Apple products for the Chinese export market, is a prime example of the importance of global supply chains in world trade. Another example is the aircraft manufacturer, Airbus, which sources its inputs from many countries.
China’s high share of exports in GDP, without subtracting the inputs used in their production, overestimates the importance of foreign trade in a country’s GDP. A lower exchange rate raises the domestic currency value of the export revenue of a firm, as well as its domestic currency value of imported inputs. This is not to say that a low exchange rate does not promote exports but the impact is lower than one would think, if imported inputs are considered. Moreover, there is often a failure to distinguish between ‘levels’ and ‘growth’. Regardless of the value of net exports, they have to grow to contribute to GDP growth.
The contribution of China’s net exports to the country’s GDP growth peaked at 2.6% in 2007, when the country’s current account surplus reached 10.1% of GDP and GDP growth reached 14.2%. But at the peak of the Global Financial Crisis (GFC) in 2009, net exports contributed -3.5% to GDP growth. In that year, 22.9% growth in domestic investment compensated for the negative contribution of net exports to produce an overall growth rate of 9.2% (IMF, 2012). The contribution of net exports to GDP growth never reached +1% after the crisis and was even negative in some years (IMF, 2018; World Bank, 2011). However, it is not uncommon to have commentators link China’s high gross export to GDP ratio as evidence of the country’s export driven growth.
What then do they know about China’s exchange rates? Commentators, including most economics commentators in the media, tend to focus on nominal exchange rates when it is the real exchange rate that matters. More often than not, no distinction is made between the nominal and real exchange rates in a discussion. This often leads to confusion when discussing the impact of China’s exchange rate on its exports. There are two primary reasons for this.
One is that commentators perfunctorily transfer the experience of the use of the exchange rate in developed countries to China. Another related reason is that there is no acknowledgment of the conditions required for the nominal exchange rate to be an effective policy instrument. In advanced countries, domestic prices are rigid and it is politically difficult, if not impossible, to lower money wages. Depreciation of the domestic currency can lower real wages, avoiding domestic deflation in the face of an economic shock. A country like Greece, unfortunately stuck in the euro zone, could not depreciate its currency during the GFC and now has to endure the subsequent deflation. But a domestic currency depreciation is no guarantee of success. If wages increase to match the price increase resulting from the currency depreciation, there will be no real effects from the depreciation.
With a booming economy, the situation in China in the last decade is very different from a country experiencing a negative economic shock. Figure 1 shows China’s real effective exchange rate (REER) from January 1970 to January 2018 (downloaded from the databank of the Federal Bank of St Louis). It shows the REER clearly depreciating from 1970 to 1994, when China combined its recently established relatively free foreign exchange market with its officially controlled foreign exchange market, and opted for a managed floating exchange rate nominally pegged to the US dollar.
With a planned economy prior economic reform, China had an overvalued exchange rate in common with other planned Soviet and East European economies. This was clearly evident with the black market rate for foreign currency trading at a significant premium over the official rate. At one time, the black market rate was more than twice the official rate. With nominal wages largely fixed by the state, devaluation of the official exchange rate lowered the REER. But from 1995 onwards, the yuan was largely pegged to the US dollar and the REER was relatively stable compared to the previous 25 years, although it continued to appreciate as a result of rising money wages. By then, wages, especially in the export sector, were largely market determined.
Figure 1: China’s real effective exchange rate: January 1970–January 2018
The boom in China’s economy with double digit growth rates until the GFC, and a still impressive growth rates of 6-7% after that, explains the appreciation of China’s REER. When there is surplus labour, a low nominal exchange rate leads to a low REER. But when a booming economy creates labour shortages, money wages will rise to drive up the REER. Policymakers in a booming economy might be able to control the nominal exchange rate, but not the REER.
The Bank for International Settlements (BIS, 2017) calculated a series of real broad RMB exchange rates. They show that from June 2005 to July 2015 the yuan appreciated in real terms by 56.9%. The yuan depreciated in nominal and real terms after July 2015 in response to China’s slowing economic growth and market uncertainty. From July 2015 to mid-December 2016, the yuan depreciated in nominal terms by 13.6% against the US dollar (Morrison, 2016, p. 50). In real terms, however, over the same period it depreciated against a broad group of currencies by only 6.2%, which meant that it still appreciated in real terms between 2005 and 2016 by 47.1% (BIS, 2017).
The long-term appreciation in the yuan REER reflects China’s growing prosperity. China is no longer a low-cost economy. China’s average wages in 1990 were below those in Vietnam and Mexico. In 2016 they were 307% higher than the wages in Vietnam and 122% higher than Mexico’s. China’s unit labour production costs in 1990 were just under half of the United States’, but increased to 75% in 2016 (Morrison, 2017, p. 12).
The US Treasury’s label of China as a ‘currency manipulator’ has no economic logic. China’s REER has been appreciating steadily since 1995. The recent small nominal depreciation of the yuan to above ¥7 to the US dollar is an expected market reaction to US tariffs and the weakening Chinese economy and exports. If anything, in recent years China has been intervening in foreign currency markets to prop up the value of its currency to counter destabilising capital outflows. China does enjoy a huge trade surplus with the US, but much of it could be explained by global supply chains in world trade. But more importantly, a country’s trade deficit is due to excess expenditure over production – a savings deficit. The US has a trade deficit with China because China is able to supply the US with goods at the lowest cost. As long as the US has a savings deficit, even if its imports from China equal zero, it will continue to run a trade deficit. China’s trade surplus with the US will then be transferred to other countries.
Bank for International Settlements (BIS), (2017) Real Broad Effective Exchange Rate for China© [RBCNBIS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/RBCNBIS, February 12.
International Monetary Fund. (2012). People’s Republic of China: 2012 Article IV consultation. Retrieved from https://www.imf.org/external/pubs/ft/scr/2012/ cr12195.pdf.
International Monetary Fund. (2018). People’s Republic of China: Staff report for the 2018 Article IV consultation.
Morrison, Wayne M. (2017), China’s Economic Rise: History, Trends, Challenges, and Implications for the United States, Congressional Research Service, 30 August.
United States Census Bureau (2019), Trade in goods with China, https://www.census.gov/foreign-trade/balance/c5700.html (downloaded 15 August 2019)
World Bank. (2011). China quarterly update, April. Retrieved from http://documents.
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